A Tough Sell

SALESFORCE.COM IS THE FASTEST-GROWING business-software company in the world, not to mention one hot stock. Yet the on-demand darling may have bitten off more than it can chew by taking on
Oracle
-- the biggest of the business-software bunch.

When Oracle reports earnings early this week, it's expected to disclose a head-to-head contract win or two over
Salesforce
(ticker: CRM) for large corporate customers. In effect, Oracle will be giving notice to its feisty rival -- which has less than 5% of Oracle's $14 billion in annual sales -- that it's ready to compete in selling robust on-demand customer-relations management software to top enterprise customers, says Cowen analyst Peter Goldmacher.

Salesforce shareholders should also take note. The stock has risen 88% in the past 52 weeks and has tripled since its initial public offering in June 2004. As the market digests more information about the challenge that Salesforce now faces, Goldmacher thinks the stock, a popular momentum play, could drop as much as 10%.

Goldmacher argues that the shares, trading at 45 times free cash flow, are pricey even taking into account the company's phenomenal growth. Salesforce's free cash flow has a compound annual growth rate of 31%, suggesting that the stock has outrun underlying growth. Another red flag: CEO Benioff has unloaded about 38% of his shares in the past two years.

Until 18 months ago, eight-year-old Salesforce rarely competed with Oracle, focusing on small and medium-sized businesses. But with great fanfare, Salesforce entered the enterprise market with a bang by landing deals with
Cisco Systems,Dell,ADP
and others.

By going after big corporate customers, Benioff also was testing his former boss, Oracle Chief Executive Larry Ellison, who isn't one to back down from a fight.

Benioff has revolutionized business software, especially sales-automation applications, by selling it as a computer service via the Internet rather than as software installed on a company's hardware.

On-demand software is expected to grow 20% to 25% annually over the next five years, compared with a 9%-to-12% rate for traditional enterprise software, says Chicago's William Blair & Co. Salesforce's system has been readily accepted by mom-and-pops because it's affordable and easy to deploy and use. But large companies have been reluctant clients because Salesforce's product sacrifices the ability to integrate and customize systems, Goldmacher explains. There's demand for both kinds of software, and many big customers want both, which should help Oracle defend its turf, Goldmacher says.

Through its 2006 acquisition of Siebel Systems, which practically invented customer-relationship software, Oracle became the dominant provider to large customers. But Siebel's pre-Oracle on-demand products delivered over the Internet fell short, giving Salesforce a big opening.

ORACLE HAS BEEN WORKING HARD IN THE PAST 18 months to develop an improved offering: Oracle CRM On Demand. Goldmacher says the completed application is up and running in an Oracle data center and is being sold. He predicts Siebel users will give it a try because it complements their previous investments in Siebel applications, integrates easily and doesn't come from a new vendor.

Price is another potential pitfall for Salesforce. Goldmacher contends that Salesforce, which already has a high cost of sales, is heavily discounting its deals to enterprise customers. Salesforce charges, on average, about $75 a month per user for its core small-business customers but fetches as little as $25 a month per user for enterprise customers, Goldmacher says. Benioff would not disclose average prices per customer.

"Enterprise is not a zero-sum game; you don't have to win every deal," says CEO Benioff.

The trouble is that Salesforce has been buying growth with little added profit. Sales soared 60% to $554.8 million in fiscal 2007 (ended Jan. 31), but margins grew only 1%, Goldmacher says. More discounted enterprise deals would pressure margins further, the analyst says.

Yet if Salesforce intends to compete for big corporate customers, it will need to continue to slash prices. If Salesforce were to get anything close to its average-price-per customer for a big client like Merrill Lynch with 25,000 users, the brokerage's price would be $20 million a year or so. "For that kind of money, Oracle would sell you all of the [CRM] software it has, and Larry [Ellison] would come over and install it himself," Goldmacher argues.

The Bottom Line

Salesforce.com shares look pricey after rising threefold in three years. And now that the small company is competing with behemoth Oracle, taking profits is sensible.

Between Oracle's revamped on-demand service, its advantage in bundling software for big customers and Salesforce's heavy discounting, Goldmacher thinks that picking a fight with Oracle and Ellison was a mistake: "Their enterprise strategy is fatally flawed," he says.

Benioff disagrees. Pointing to the quality of his enterprise-CRM customers like Cisco, he argues that seeking enterprise business was a wise move. To suggest otherwise is "insanity," he says. "Enterprise is not a zero-sum game; you don't have to win every deal," Benioff says.

Aside from his other challenges, Microsoft is expected to enter the on-demand business-software market in late summer, with a new CRM service that's code-named Titan, which will compete directly against Salesforce.

After having the small-business market mostly to itself, Salesforce will be battling Oracle on one front and
Microsoft
on another. That isn't easy.

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